Small Banks, Big Payoffs

As we move into the final weekend of 2012, I will offer up my final idea for 2013. You will be shocked to know that it is not a lot different than my first idea for this year. The trade of the decade in small banks is still very much alive and many of these stocks are still cheap enough to buy. We saw some signs of the start of the long-awaited mergers-and-acquisitions (M&A) wave and it will accelerate over the next 12 months. A whole slew of new regulations, along with attendant compliance costs, are set to take effect in the next year, and small banks will find it easier to sell to larger institutions that try to comply.

I recently had a chance to talk with an old friend who has been around the banking business for decades. He is currently on the board of one small bank and owns stakes in several others. He said that he was getting tired of active involvement in banking. Small bankers have gone from respected pillars of the community to pariahs who caused the financial meltdown and foreclosed on friends and relatives. This attitude is pervasive among consumers and it makes for weary bankers. In addition, making solid earnings gains is going to be difficult, if not impossible, under the new regulations; therefore, many bankers are looking to sell and move on.

But don't get the incorrect idea that this will be a fire sale. Most of the officers and directors of the smaller banks own substantial blocks of stock in the companies and they will not give it away. They know what their banks are worth and will hold out for a reasonable price. Patience will pay off -- both insiders and those of us who are outside as passive investors. Larger banks face many of the same problems as their smaller brethren and they also face pressure to grow. In such a weak economy, it is hard to grow organically so acquisition becomes the path to profits for many banks.

In addition to the small bank theme I also like many of the large regional banks. Their credit issues are solidly behind them and they should be able to grow by buying smaller banks and taking market share from the money center institutions. I think you can buy stocks like Key Corp. (KEY) and Huntington Bancshares(HBAN) around current levels and plan on adding the position if the shares fall to less than 80% of tangible book value in a market decline. First Niagara (FNFG) is another larger institution that is cheap enough to buy at current levels.

I am also a big fan of the story and financial condition at Capital Bank Financial (CBF). The bank was formed by the merging of several healthy banks and adding in FDIC acquisitions. Formerly known as North American Financial, the bank now has a solid presence in the southeastern U.S. and plans to grow further over the next several years by acquiring smaller banks in the region. In just two years, the company has completed seven deals, combined them into one entity and completed the IPO of the new bank.

Management thinks the Southeast is a target-rich environment. In all, it has 340 banks in its planned service area and 154 of those are stressed or under enforcement action. These banks can be acquired at bargain prices and often include government assistance and loan guarantees. Management has already proven they know how to build a bank under these conditions. Plus, with the shares trading at 83% of tangible book value, they are a great bet on a sustained banking recovery. The assets purchased under stressed conditions today should provide handsome returns as the economy and real estate markets recover over the next five years.

I am a big fan of the conversion trade for 2013. I have discussed several times that those thrifts who converted to stock ownership during the depths of the financial crisis have not seen the same type of takeover activity as is historically normal. Quality, cheap banks, such as Westfield Financial (WFD), Essa Bancorp (ESSA) and a host of smaller conversions, will see strong operating improvements this year with a good chance of takeover bids added in. Sorting through the filings of thrift conversions since 2006 that are still public is a worthwhile exercise for bank stock investors.

These are just a few of the stocks I like for the trade of the decade. Most of my favorite picks are far too small to mention here. There is an enormous amount of money to be made over the next five to 10 years in banks but it will require both leg work and homework. Finding those small institutions at large discounts form book value and solid balance sheets is well worth the time and effort. It is one of the best opportunities long-term value investors will see in 2013.